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Buy Safeway ($22.85)

Safeway's (NYSE:SWY) disappointments in sales and profitability for the past couple of years have largely been the result of food deflation. Admittedly, some of that deflation has been self-induced by SWY, as it compensates for being out of step with its customers entering the recession. And going into the recession, it's own mis-steps on price were met by an especially promotional environment. However, the company's spent the past five or six quarters advertising lower prices as well as actually bringing down the cost per item, as evidenced by volume that’s flattened over the past six months. Today, with store growth essentially halted about five years ago, SWY must grow comparable or identical store sales, via higher prices, to favorably surprise investors, assuming traffic at least stabilizes at these flat levels.

Reduced promotional activity by competitors should help lay the groundwork for better pricing at the company. SWY management recently reported its pricing in the US had begun to improve early in the current quarter (Q4), as customers now perceive its prices on par with peers’. Investors shouldn’t expect price per item to jump – a positive turn entering 2011 would suffice – recent deflation ought to be viewed as an anomaly, since grocery store industry prices had risen 3% a year for the decade prior to 2008.

Same Store / ID Sales (ex fuel)

11E

10E

09

08

07

(RDK)

0.0%

-1.1%

-1.5%

2.9%

4.9%

(WFMI)

6.0%

6.5%

-4.3%

3.6%

5.8%

SWY

1.5%

-1.5%

-2.5%

0.8%

3.4%

(NYSE:KR)

3.0%

2.5%

2.1%

5.0%

5.3%

(NYSE:WAG)

2.0%

1.6%

2.0%

4.0%

8.1%

(NYSE:CVS)

1.5%

2.2%

5.0%

4.5%

5.3%

Avg

2.3%

1.7%

0.1%

3.5%

5.5%

My base case scenario forecasts a 1 - 2% overall identical sales (ex fuel) comparison in 2011, about evenly split between price and volume. However, even on this modest growth in organic sales, I expect the operating margin to climb by 50 basis points next year. At this level of margin improvement, nearly half of the drop in EBIT margin since 2008 would be closed.

About half of the margin improvement I expect is the result of a structural decline in operating costs (which management says will reach around $400 million annually), owing to sales leverage, further shrink improvements and reduced labor costs. Note that headcount fell 5.6% in 2009. Although the company hasn’t updated investors for employee count in 2010, it has expensed $26 million in severance and employee buyout charges in Q2 and Q3 2010, suggesting low- to mid-single digit drop in employee count this year.

EBIT Margin

11E

10E

09

08

07

RDK

4.7%

4.5%

3.8%

4.4%

4.2%

WFMI

5.1%

4.8%

3.5%

3.6%

4.5%

SWY

3.4%

2.9%

3.3%

4.2%

4.2%

KR

2.5%

2.5%

2.9%

3.2%

3.4%

WAG

5.6%

5.1%

5.1%

5.8%

5.9%

CVS

6.6%

6.5%

6.5%

6.9%

6.3%

Avg

4.7%

4.4%

4.2%

4.7%

4.7%

Consistent with my base case scenario is free cash flow (FCF) exceeding $1 billion, or around an 8% yield, in 2010, as the Lifestyle store conversions and roll-out are winding down. The FCF I expect in 2010 is about 5% better than 2009, its first year of less than $1 billion in capex. The company realizes food retail is no longer a growth industry, and I take it at face value when management says it will not meaningfully increase capex when the economy improves. Thus, I tie FCF growth over the next five years to operating profit increases of around 8%. This discretionary cash will go toward buying back stock – outstanding shares will have fallen by 15% at yearend vs. December 2008 – and higher dividends, which have climbed about 20% a year since 2005, when SWY first began its payout.

I value SWY at $36, based on the average of DCF and EBITDA multiple based approaches. Growth on my five year DCF, as outlined above, uses a terminal value multiple of 14X, and discounts these amounts by 8%. On my 2011 EBITDA forecast of $2.6 billion I apply a 6.5X multiple, which is the average of its yearend 2007 (7.9X) and 2008 (5.2X) multiples of EBITDA. I chose these years because their denominators represent the range of EBITDA of $2.6 bn (’07) and $3 billion (’08) that I believe SWY will achieve over the next three years.

EV/EBITDA
PE
11E
10E
09
08
07
11E
10E
09
08
07
RDK
5.9x
6.3x
5.8x
5.7x
7.8x
15.5x
16.5x
13.5x
13.8x
20.8x
WFMI
10.2x
11.4x
8.3x
4.1x
13.5x
25.0x
33.0x
38.5x
11.5x
31.7x
SWY
5.1x
5.6x
5.2x
5.2x
7.9x
11.6x
14.4x
11.2x
10.7x
16.9x
KR
5.4x
5.7x
5.5x
6.5x
7.1x
11.7x
12.9x
10.1x
13.9x
15.8x
WAG
6.9x
7.9x
8.6x
6.0x
10.2x
14.3x
16.6x
18.1x
11.4x
18.8x
CVS
6.4x
6.7x
7.3x
7.4x
20.1x
11.6x
12.3x
12.6x
13.1x
20.7x
Avg
6.6x
7.3x
6.8x
5.8x
11.1x
14.9x
17.6x
17.4x
12.4x
20.8x

Disclosure: Accounts I manage have a long position in SWY.

Source: A Turn for the Better at Safeway